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A Limited Exception

The California Department of Business Oversight has enacted final rules to implement an exemption from broker-dealer registration licensing requirements in California for individuals acting as “finders” in securities transactions. The exemption clarifies the scope of permissible activities and allows for transaction-based compensation for finders in California, but companies considering using a finder should pay close attention to ensure that several conditions and procedural requirements are met.

Many early-stage companies use the services of a finder, an individual or entity that identifies potential investors, when raising capital. Unbeknownst to many entrepreneurs, however, such arrangements may violate federal and state securities law, as finders may be subject to broker-dealer regulations. Both federal and California law require any person engaged in “effecting transactions” in securities to acquire a broker-dealer license. Often, agreements with finders violate broker-dealer regulations because they involve transaction-based compensation or because the finder’s activities fall outside the narrow scope of permissible activities for an unregistered person.

The consequences of non-compliance with broker-dealer regulations can be severe for the company as well as the finder. In addition to possible civil and criminal penalties, using an unlicensed broker-dealer creates a voidable transaction under both federal and California law and any investors involved have a rescission right. Thus, companies that engage unlicensed finders to raise capital take on considerable risk.

Recognizing the importance of finders in promoting the capital formation of small businesses, in 2015 the California Legislature enacted an exemption from broker-dealer registration requirements for individuals acting as finders in securities transactions in California under §25206.1 of the Corporations Code. Recently, the California Department of Oversight enacted final rules 10 CCR §260.211.4-§260.211.7 to implement this exemption.

The exemption creates a framework for a finder to engage in certain activities in securities transactions in California and receive transaction-based compensation without a broker-dealer license. However, the scope of its application is limited, and companies should be careful to ensure that the exemption’s conditions and procedures are satisfied.

To receive the exemption, a finder must comply with certain procedural requirements. First, before engaging in any activities in reliance on the exemption, the finder must file a Statement of Information confirming that the finder has complied with the exemption conditions and pay a fee of $300. Second, the finder must file a renewal statement annually and pay a fee of $275, as well as make periodic updates as appropriate. Third, for each transaction in which the finder participates, the finder must make certain disclosures and obtain the issuer’s and investors’ consent through a written agreement.

If a company is considering engaging a finder for a securities transaction in reliance on this exemption, the company should first ensure that the following qualifications are met:

The finder is a natural person, not an entity.

The transaction, issuer, finder and investors are all in California.

The transaction involves only accredited investors and has an aggregate purchase price of $15 million or less.

When meeting with a potential finder, a company should ask the following questions:

Have you filed a Statement of Information annually with the Commissioner and paid the applicable filing fees?

Have you complied with the permissible scope of securities activities when participating in securities transactions?

Have you made the required disclosures and obtained written agreements with each investor and issuer for each transaction in which you have participated?

Do you maintain records of the notice, written agreement, and all other documents associated with a transaction in which you have participated for the last five years?

Further, if a company elects to use a finder, the company should seek to ensure that the finder does not: (i) participate in negotiating any of the terms of the offer or sale of the securities; (ii) advise any party regarding the value of the securities or the advisability of investing in, purchasing, or selling the securities; (iii) conduct any due diligence; (iv) sell any securities of the issuer owned by the finder; (v) receive possession or custody of any funds in connection with the transaction; or (vi) disclose issuer information except certain permitted information. If a finder engages in any of these activities or otherwise fails to follow the requirements of the exemption, the finder becomes ineligible for this exemption.

Companies should note that the exemption only applies to broker-dealer licensing requirements governed by California law. Therefore, finders and companies must still comply with all other state securities laws and all federal securities laws, as applicable, when conducting activities related to the offer and sale of securities. There is not currently a similar exemption from the federal broker-dealer licensing requirements for finders.

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